A so-called smart money indicator can be a tip off to what side of the market insiders are positioning. Market action for options can be used to predict future market direction.
Put options are used to hedge or speculate on downward prices, where call options are for upside protection or participation. Measuring that option demand can be helpful in determining market sentiment at any moment in time.
The Chicago Board of Option Put/Call Ratio (CBOE) measures option volume activity at the leading US option exchange.
Here’s a simple calculation:
PUT/CALL RATIO = Put Volume / Call Volume
The movement above or below the zero line signals a shift option demand.
The CBOE total put/call ratio is a combination of index and equity option data to balance each others shortcomings.
In general terms, index options are used by institutions and professionals that often have a bias towards puts as protection. Equity options on the other hand, are retail products with calls more common as bullish vehicles.
As with most other technical indicators, the put/call ratio has limited application as a pure number by itself. The price is relative with not absolute bullish or bearish market signals.
The 1.20 Bullish and .70 Bearish levels are watched for extremes.
The put/call ratio is often used as a contrarian indicator to signal a turning point when the sentiment becomes too overloaded on one opinion. If everyone is extremely bullish or bearish as viewed by the option ratio, a corrective action may reverse market.
Usually, the crowd is wrong at the top or bottom of moves, expecting much more. With that thinking, the put/call ratio reflects that frenzy of one sidedness that can be a precursor to the market turn.
The ratio reaction can signal a capitulation with an extreme high or low. But remember that the put/call ratio can always get more extreme.
